Prime Brokerages Consolidate After "Big Bang"

Hedge funds are cutting back
on the brokerage accounts they hold as the prime brokerage
industry begins to consolidate more than four years after the
Lehman Brothers bankruptcy blew the sector wide open.

Hedge funds are cutting back
on the brokerage accounts they hold as the prime brokerage
industry begins to consolidate more than four years after the
Lehman Brothers bankruptcy blew the sector wide open.

The shift comes as prime brokerages are facing increasing
challenges. New capital regulations are raising costs, while low
interest rates, reduced use of leverage and less hedge fund
activity pressure revenues.

That shift is likely to hurt the smaller primes that
flourished after the crisis and are now seeing their offerings
increasingly commoditized, while entrenching the leadership of
the top-tier players such as Morgan Stanley, Goldman
Sachs Group Inc and JPMorgan Chase & Co.

It is also likely to lead to a rise in funding costs for the
hedge fund industry, particularly when certain shorting
strategies are less lucrative for the broker.

"What it's doing is segmenting the industry and making an
industry where the top-tier players again are controlling the
big market share and the industry is going back to having few
providers in the prime brokerage space," said Matt Simon, a
senior analyst at Tabb Group, who monitors prime brokerages.

After Lehman went under in 2007, "counterparty risk" became
a key watchword for hedge funds, which faced the very real
possibility of their assets being caught up in lengthy
bankruptcy proceedings. As a result, they diversified.

In 2009, hedge funds with over $3 billion in assets had an
average of 4.8 prime brokers, according to Tabb Group. Funds
typically had just one broker before the crisis.

But that disaggregation is reversing, falling to 3.9 in 2010
and to 2.9 brokers in 2011.

After the financial crisis, lower-tier players such as
Deutsche Bank AG and Citigroup Inc tried
- and succeeded - to take market share from the traditional
duopoly of Morgan Stanley and Goldman Sachs, while a number of
smaller primes ramped up their operations.

That jockeying for position came ahead of an expected
renaissance that has so far had mixed blessings for the
industry.

Hedge fund assets, which peaked at $2.2 trillion in 2007,
rebounded dramatically after the financial crisis. They fell to
$1.4 trillion in 2008, but are now around $2 trillion.

But successive crises and volatile, correlated markets have
sapped investor confidence, hitting trading, which in turn is
hurting prime brokerages. Average daily U.S. trading volume so
far in 2012 is 6.83 billion shares, down from 7.84 billion in
2011.

"The internal cost of funding is really quite high," said
Robert Lyons, the former chief operating officer at Bear Stearns
Global Equities, a post that had the prime brokerage business
under its purvey.

Lyons describes a recent conversation he had with a head of
prime brokerages at major firm: "I talked to the head of PB and
he said 'we're barely breaking even.'"

Total revenue for prime brokers is hard to establish. Lyons
estimates it has fallen to around $12 billion a year from $15
billion in 2008.

Revenue for Goldman Sachs' prime brokerage have fallen a
whopping 53 percent to $1.6 billion in 2011 from $3.4 billion in
2008, according to data tracked by Global Custodian. Although
some of that is due to falling market share, it also tells a
story about declining revenues across the industry.

"With the volume of trading so low and the volatility so low
there really isn't enough to feed everybody at the table right
now," said Ron Suber, a senior partner at Merlin Securities, a
New York-based prime broker that aims to attract hedge funds in
the $100 million to $1 billion range.

That will also mean that funding costs for hedge funds are
likely to increase, says Suber.

"With Basel III coming, the expenses to run a prime
brokerage business and do financing on certain asset classes are
increasing," he said. "So we are seeing as an industry where
many prime brokers are calling hedge funds and increasing rates
on margin financing on less liquid securities, anywhere from 2
to 7 basis points."

Basel III will impose stricter regulations on reserve
capital requirements for banks. This means prime brokerages are
less willing to finance clients if the returns are not big
enough. That has even led to primes politely showing smaller
clients the door.

Under those conditions, prime brokerages are telling clients
that the relationship is not going to work unless they start
executing all their trading business through them. Prime
brokerages can be attractive to parent banks if they pull in
other, more lucrative business.

"With the new regulation, balance sheets become a bit more
precious," said Lou Lebedin, global head of prime brokerage at
JP Morgan. "In those situations, where clients have a very tight
spread and are using a lot of the balance sheet, it is not
uncommon for us to go back to them and explain to them how the
economics look from our perspective."

JP Morgan became a major prime broker in 2008 when in bought
the failed Bear Stearns. It is attractive to clients because of
its "fortress" balance sheet.

Lebedin says clients who are only shorting and not using
leverage on the long side are most often a cause for concern
because the bank's balance sheet is absorbing more short
exposure.

In addition, many of the shorted stocks are cheaply borrowed
'general collateral' securities that might be used in vanilla
arbitrage strategies rather than more lucrative 'hard-to-borrow'
stocks. That makes the return for the broker far less
attractive.

The lack of hard-to-borrow stocks or 'specials', in-demand
stocks that command a greater premium for lenders and brokers,
is due to a number of factors.

Fewer mergers and acquisitions and a tendency for deals to
be carried out in cash by cash-rich companies reduce
opportunities for arbitrage in the shares of the acquirer and
the target company, a source of borrower demand.

In addition, there are also fewer initial public offerings
that create a market in hard-to-borrow stocks for short sellers.

Less M&A and IPO activity is largely the result of the same
market and economic conditions that have driven correlation in
markets and have kept hedge funds cautious. Global M&A fell to
its lowest in seven years in the first quarter, according to
Thomson Reuters.

"The hedge fund market has improved, but the activity levels
haven't picked up as much as what one would expect," said Brad
Hintz, an analyst at Bernstein. "There is just too much
collateral chasing way too few people that are shorting."

Hintz says that for lending revenues for prime brokers to
increase interest rates need to rise. In the United States,
borrowers typically post cash collateral for borrowed stock,
which is reinvested by lenders. While interest rates are
ultra-low the return will be much less.

"Everyone in the industry is waiting for the recovery," said
Hintz. "Waiting for securities lending to rebound; for cautious
clients to come back to the market and for rates to rise."
(Editing by Andre Grenon)

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